Saturday, October 18, 2008

Wall Street Journal: Bernanke is fighting the last war

In an interview with Brian Carney of the Wall Street Journal, Anna Schwartz argues that the U.S. Federal Reserve and Treasury are going at solving the crisis the wrong way. She argues that the problem is a crisis of confidence - i.e. banks don't trust the creditworthiness of potential customer or other banks enough to make loans - but that the Fed is attacking the crisis as if the problem was a liquidity crunch, i.e. not enough money.

The latter was true during the Depression. She argues that it isn't true now, and that the Fed and Treasury should have executed the original bailout plan, which involved purchasing mortgage related securities from banks. Instead, the Fed has cut interest rates and the Treasury is making direct investments in banks. If she's right, the Fed and Treasury are basically keeping afloat firms which should be insolvent.

She further argues that accommodative monetary policy (i.e. expanding the supply of money by keeping interest rates low) produces asset bubbles (e.g. tech and housing bubbles), and that central banks should maintain cautious monetary policies so that they don't develop. She takes issue with Alan Greenspan, who once said, "There is a fundamental problem with market intervention to prick a bubble. It presumes that you know more than the market." In other words, he probably believes that central banks can not safely deflate an asset bubble.

Schwartz doesn't explicitly say in the article that a central bank should intervene to deflate an asset bubble (probably by raising interest rates). However, I believe she implies that central banks should not allow them to inflate in the first place. If she is right that the Fed and Treasury are currently fighting the wrong battle, then we might expect another asset bubble to inflate down the road. It's impossible to predict what it will be, although one person I talked to speculated that it would be in the alternative energy industry.

I do not specialize in macroeconomics and cannot thoroughly assess the soundness of Schwartz's arguments. I suppose only time will tell.

Schwartz, 92, (still!) works at the National Bureau of Economic Research. She co-authored the book A Monetary History of the United States with Milton Friedman; the book chronicled the history of the Great Depression.

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